Hopeful on High-Yield Bonds

High-yield bonds are looking like a high-wire act for 2005.

Funds specializing in so-called junk bonds, or noninvestment-grade corporate debt, saw their second straight year of outsize returns in 2004. Investors in these funds can thank a recovering economy and an accommodative Fed.

Two straight years of strong returns, along with widespread predictions that interest rates will rise, are making some junk bond holders anxious. And Pimco manager Bill Gross' claim that cash is looking better than bonds of all stripes for 2005 isn't helping to soothe any rattled nerves either.

Even so, some analysts are telling investors to expect another "solid, if unspectacular" year.

"Don't sell high-yield until you see the whites of the eyes of recession," says Greg Hopper, portfolio manager for the (BJBHX - Cramer's Take - Stockpickr)Julius Baer Global High Yield fund. "And we are not close to seeing that yet."

Recession snuffed out the high-yield market in 2001 and 2002, when the staggering economy made it difficult for cash-strapped companies to meet big coupon payments. GDP growth slowed to less than 1% in 2001 and just under 2% in 2002. As a result, high-yield defaults rose to record levels in those years, hitting a high of 10.9% in January 2002, according to Moody's.

The ensuing recovery boosted high-yield returns to equitylike levels, though -- much of it from capital appreciation as opposed to yield. According to Morningstar, high-yield fund returns averaged 24% in 2003 and 9.8% last year, nearly on par with the S&P 500's gains. Default rates have since dropped to 2.5%. And economists expect GDP growth to be in the mid-3% range for 2005, which fund managers say bodes well for economically sensitive high-yield issues.

"High-yield should be one of the best performing fixed-income asset classes in 2005," says Kathleen Gaffney, portfolio manager for the (LSBRX - Cramer's Take - Stockpickr)Loomis Sayles Bond Return fund. "It's mostly going to be coupon-clipping since much of the capital appreciation has been wrung out, but it still beats Treasuries by a long shot."